Indicate by check mark whether the registrant:
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days. Yes þ No o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Exchange
Act). Yes þ No o

Number of shares outstanding of the
registrants Common Stock as of November 8, 2004:

We are a biotechnology company engaged in the
research and development of small molecule cancer therapeutics
based on a novel biological approach to cancer, our Activated
Checkpoint TherapySM
(ACTSM) platform, and our expertise in small
molecule chemistry and intelligent drug design. We also provide
fee-based services to pharmaceutical companies and biotechnology
companies, using our chemistry-based technology and expertise to
attract collaborators. We have an experienced and highly
qualified scientific and management team that can apply our
chemistry technology platform to produce compounds that have
medicinal attributes.

We are subject to risks common to companies in
the biotechnology, pharmaceutical, medical services, and
diagnostics industries, including but not limited to,
development by the Company or our competitors of new
technological innovations, dependence on key personnel,
protection of proprietary technology, and compliance with
governmental regulation.

2.

Basis of Presentation

We have prepared the accompanying consolidated
financial statements pursuant to the rules and regulations of
the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to these
rules and regulations. These consolidated financial statements
should be read in conjunction with our audited financial
statements and footnotes related thereto for the year ended
December 31, 2003 included in our annual report on
Form 10-K filed with the Securities and Exchange Commission
on March 12, 2004. These unaudited consolidated financial
statements include, in our opinion, all adjustments (consisting
only of normal recurring adjustments) necessary to present
fairly our financial position as of September 30, 2004, and
the results of our operations for the three months and nine
months ended September 30, 2004 and September 30, 2003
and cash flows for the nine months ended September 30, 2004
and September 30, 2003. The results of operations for such
interim periods are not necessarily indicative of the results to
be achieved for the full year.

3.

Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of
net income (loss) and other comprehensive income. Other
comprehensive income includes certain changes in
stockholders equity that are excluded from net income
(loss), including unrealized gains and losses on our
available-for-sale securities and interest rate swaps and
foreign currency translation amounts. Comprehensive income
(loss) for the three and nine months ending
September 30, 2004 and September 30, 2003 were as
follows (in thousands):

Three Months Ended

Nine Months Ended

September 30,

September 30,

2004

2003

2004

2003

Net income (loss)

$

1,472

$

(29,909

)

$

(3,912

)

$

(29,622

)

Unrealized gain (loss) on securities and
interest rate swaps

233

16

(171

)

93

Foreign currency translation adjustments



(2

)

86

(54

)

Comprehensive income (loss)

$

1,705

$

(29,895

)

$

(3,997

)

$

(29,583

)

4.

Restructuring Actions

In the first quarter of 2004, we implemented a
restructuring to shift resources from our chemical technologies
business to our internal cancer therapy research. The
restructuring included the termination of

53 staff and managerial employees, or
approximately 18% of the workforce, in the following areas: 30
in chemistry production positions, 7 in chemistry-based research
and development positions and 16 in administrative positions. In
connection with these actions we recorded a restructuring charge
of $1.1 million in the first quarter of 2004 for
termination benefits.

In connection with a restructuring in December
2002, we recorded a restructuring charge related to the closure
of our facility in Redwood City, California. As of
December 31, 2003 we had a remaining accrual of
$6.2 million that primarily represented the remaining lease
payments on our primary lease obligation less an estimate of
sublease income. In the third quarter of 2004, we entered into a
sublease for the California facility with Threshold
Pharmaceuticals, Inc. The term of the sublease extends through
2010, the remaining term of the Companys primary lease
obligation. As a result of signing the sublease, we reassessed
the remaining restructuring accrual and, since the sublease was
on terms more favorable than previously estimated, we recorded a
$1.5 million restructuring credit in the third quarter of
2004.

Year-to-date activity against the restructuring
accrual (which is included in accrued liabilities in the
Consolidated Balance Sheet) was as follows (in thousands):

Balance as of

2004

Balance as of

December 31,

Provisions/

2004

September 30,

2003

(Credits)

Payments

2004

Termination benefits

$

10

$

1,072

$

(1,082

)

$



Facility-related

6,160

(1,496

)

(1,024

)

3,640

Other charges

69



(69

)



Total restructuring accrual

$

6,239

$

(424

)

$

(2,175

)

$

3,640

As of September 30, 2004, all employee
termination benefits had been paid. The facility-related
accrual, which is primarily comprised of the difference between
the Companys lease obligation for its California facility
and the amount of sublease payments it will receive under its
sublease agreement with Threshold Pharmaceuticals, Inc., will be
paid out through 2010.

5. Net Income
(Loss) Per Share

The computations of basic and diluted net income
(loss) per common share are based upon the weighted average
number of common shares outstanding and potentially dilutive
securities. Potentially dilutive securities include stock
options. The computations of net loss per share for the nine
months ended September 30, 2004 and the three and nine
months ended September 30, 2003 excluded options to
purchase 4,541,000 and 4,080,380 shares common of stock,
respectively, since inclusion of such shares would have an
anti-dilutive effect on net loss per share.

We apply APB No. 25 and related
interpretations in accounting for option grants under the
Companys stock option plans. Had compensation cost been
determined based on the estimated fair value of options at the
grant date consistent with the provisions of SFAS No. 123,
as amended by SFAS 148, our pro forma net

income (loss) and pro forma basic and
diluted net income (loss) per share would have been as
follows for the three and nine months ended September 30, 2004
and 2003 (in thousands, except per share data):

Three months ended

Nine months ended

September 30

September 30

2004

2003

2004

2003

Net income (loss):

Net income (loss) reported

$

1,472

$

(29,909

)

$

(3,912

)

$

(29,622

)

Add: Stock based employee compensation expense
included in reported net income (loss)

For the purposes of pro forma disclosure, the
estimated value of each employee and non-employee option grant
was calculated on the date of grant using the Black-Scholes
option-pricing model. The Black-Scholes option-pricing model was
developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. In
addition, option-pricing models require the use of highly
subjective assumptions, including the expected stock price
volatility. Because our employee stock options have
characteristics significantly different from those of traded
options, and because changes in the subjective assumptions can
materially affect the fair value estimates, in managements
opinion, the existing models do not necessarily provide a
reliable single measure of the fair value of its employee
stock-based compensation. The model was calculated using the
following weighted-average assumptions: no dividend yield for
all years; volatility of 95% for 2003 and 2004; risk-free
interest rates of 3.85% in 2003 and 3.5% in 2004; and expected
lives of five years for 2003 and 2004 for options granted.

6. Contingencies 
Medford Lease

We lease approximately 56,000 square feet of
laboratory and office space in Medford, Massachusetts. We lease
this facility from Cummings Properties, LLC
(Cummings) under two lease agreements, one of which
expires on July 30, 2005 and one of which expires on
July 30, 2006. We sublease a portion of these facilities
pursuant to a sublease agreement.

On August 1, 2001, Cummings significantly
raised our rent on the lease that expires July 30, 2006. We
believe this increase to be in excess of that which is
permissible under the lease agreement. Accordingly, on
January 16, 2002, we brought a complaint for declaratory
relief and damages against Cummings arising, in part, out of
Cummings attempts to increase the lease rates.
Nevertheless, during the pendency of this dispute, we are paying
the rental rates proposed by Cummings. We seek recovery of the
excess funds that we have already paid, and continue to pay,
under protest. Management has made an estimate of the most
likely outcome of this contingency and has concluded that no
provision is required at September 30, 2004. However, if we
are unsuccessful in our claim against Cummings and must pay all
or a portion of the rental expense increase currently proposed
by Cummings, we may be required to record an additional expense
of up to approximately $450,000 to record the difference between
our contractual rental payments and contractual sublease rental
income over the remaining period of the lease. Conversely, if
the contingency is resolved in our favor and we are entitled to
a refund of amounts previously paid, we may record a gain in a
future period.

Since the inception of our relationship with
Pfizer Inc. in 1999, we have produced collections of chemical
compounds exclusively for Pfizer using our automated high-speed
compound production system. Pfizer also received a non-exclusive
license to use this system in its internal production program.
We expanded this contract in December 2001 to a seven-year
agreement. We renegotiated this contract again in early February
2004. Under the amended terms of the contract ArQule will
continue to work with Pfizers scientists to more closely
match its compound deliveries to those libraries which Pfizer
believes have the greatest developmental opportunity. Under this
new agreement, ArQule will maintain compound deliveries at
approximately the same level to be supplied in 2004 instead of
increasing compound deliveries as specified in the previous
agreement. If our amended relationship with Pfizer is
successful, we could earn up to $291 million over the term
of the contract (20012008). This amendment will result in
a decrease in the total potential contract value of
$54 million compared to the terms agreed to in 2001.

In May 2003, the Financial Accounting Standards
Board issued Emerging Issues Task Force 00-21, Accounting
for Revenue Arrangements with Multiple Deliverables,
(EITF 00-21). EITF 00-21 became effective for
contracts entered into after July 1, 2003 and addresses how
to determine whether an arrangement involving multiple
deliverables contains more than one unit of accounting for
purposes of revenue recognition. In applying the guidance,
revenue arrangements with multiple deliverables can only be
considered as separate units of accounting if: a) the
delivered item has value to the customer on a standalone basis,
b) there is objective and reliable evidence of the fair
value of the undelivered items and c) if the right of
return exists, delivery of the undelivered items is considered
probable, and substantially in the control of the vendor. If
these criteria are not met, the revenue elements must be
considered a single unit of accounting for purposes of revenue
recognition. We concluded that the modification was substantial
enough to require evaluation of the contract to determine if
EITF 00-21 applied. We concluded that because the contract
does contain multiple deliverables (license to technology,
research services and compound deliveries) EITF 00-21 did apply.
We further determined that there was insufficient evidence of
fair value of the undelivered elements (compound delivery), and
therefore the amended contract represented a single unit of
accounting for revenue recognition purposes. As a result, in the
first quarter of 2004 ArQule began treating the amended Pfizer
agreement as a single unit of accounting and recognizing revenue
based on the delivery and acceptance of compounds against the
contractual compound delivery schedule.

8. Hoffmann-La
Roche

On April 2, 2004, ArQule announced an
alliance with Hoffmann-La Roche (Roche) to discover
and develop drug candidates targeting the E2F biological
pathway. The alliance includes a compound which is currently in
phase 1 clinical development. Under the terms of the
agreement, Roche obtained an option to license
ArQules E2F program in the field of cancer therapy.
Roche provided immediate research funding of $15 million,
and financial support for ongoing research and development.
ArQule is responsible for advancing drug candidates from early
stage development into phase 2 trials. Roche may opt to
license worldwide rights for the development and
commercialization of products resulting from this collaboration
by paying an option fee. Assuming the successful development and
commercialization of a compound under the program, ArQule could
receive up to $276 million in pre-determined payments, plus
royalties based on net sales. Additionally, ArQule has the
option to co-promote products in the U.S.

ArQule considers the development portion of the
arrangement to be a single unit of accounting under
EITF 00-21 for purposes of revenue recognition, and will
recognize the initial and ongoing development payments as
research and development revenue over the maximum estimated
development period. We estimate the maximum development period
could extend until December 2009, although this period may
ultimately be shorter depending upon the outcome of the
development work, which would result in accelerated recognition
of the development revenue. Milestone and royalty payments will
be recognized as revenue when earned. The cost associated with
satisfying the Roche contract is included in research and
development expense in the Consolidated Statement of Operations.

Managements Discussion and Analysis
of Financial Condition and Results of Operations

Overview

We are a biotechnology company engaged in the
research and development of small molecule cancer therapeutics.
We also provide fee-based chemistry services to pharmaceutical
and biotechnology companies to produce novel chemical compounds
with drug-like characteristics.

We have incurred a cumulative net loss of
$188 million from inception through September 30,
2004. Our losses prior to the acquisition of Cyclis
Pharmaceuticals, Inc. (Cyclis) in September 2003
related to development activities associated with our chemistry
services, the associated administrative costs required to
support those efforts, and the cost of acquisitions. We expect
research and development costs to increase in 2004 as we pursue
development of our cancer programs. We do not expect to make
additional investments to expand chemistry services capacity
during 2004. Although we have generated positive cash flow from
operations for the last five years, we have recorded a net loss
in all but one of those years, and expect to record a loss for
2004. Based on our cash position at the end of 2003, we believe
we will be able to dedicate approximately $25 million per
year over the next three years to our oncology research and
development program. This estimate is based upon the assumption
that we will continue to operate our chemistry services on a
cash flow positive basis, and that we will invest in cancer
related research and development.

Our revenue is primarily derived from compound
development chemistry services performed for our customers and,
beginning in 2004, oncology research and development funding
from collaborators. Revenue, expenses and gross margin fluctuate
from quarter to quarter based upon contract deliverables and the
timing of the recognition of revenue under our revenue
recognition policy (see the discussion of this under
Critical Accounting Policies below). As we increase
our activities in cancer related research and development, the
timing and extent of these efforts, together with the length and
outcome of our clinical trials, will further impact the
fluctuation of results from operations.

In February 2004, we amended our contract with
Pfizer. Under the amended terms of the contract ArQule will
continue to work with Pfizers scientists to match more
closely its compound deliveries to those libraries which Pfizer
believes represent the greatest developmental opportunities.
Under this new agreement, ArQule will maintain compound
deliveries at approximately the same level to be supplied in
2004 instead of increasing compound deliveries as specified in
the previous agreement. If our amended relationship with Pfizer
is successful, we could earn up to $291 million over the
term of the contract (20012008). This amendment will
result in a decrease in the total potential contract value of
$54 million compared to the terms agreed to in 2001.

On April 2, 2004 we announced an alliance
with Roche to discover and develop drug candidates targeting the
E2F biological pathway. The alliance includes a compound that is
currently in phase 1 clinical development. Under the terms
of the agreement, Roche obtained an option to license our E2F
program in the field of cancer therapy. Roche provided immediate
research funding of $15 million, and will provide financial
support for ongoing research and development. We are responsible
for advancing drug candidates ranging from early stage
development to phase 2 trials. Roche may opt to license
worldwide rights for the development and commercialization of
products resulting from this collaboration by paying an option
fee. Assuming the successful development and commercialization
of a compound under the program, we could receive up to
$276 million in pre-determined payments, plus royalties
based on net sales. Additionally, we have the option to
co-promote products in the U.S.

This report, including the Managements
Discussion and Analysis of Financial Condition and Results of
Operation (MD&A), contains statements reflecting
managements current expectations regarding our future
performance. These statements are forward looking
statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Forward-looking
statements also may be included in other statements that we
make. All statements that are not descriptions of historical
fact are forward-looking statements, based on estimates,
assumptions and projections that are subject to risks and
uncertainties. These statements can generally be identified by
use of terminology such as believes,
expects, intends, may,
will, should, anticipates or
similar

terminology. Although we believe that the
expectations reflected in such forward looking statements are
reasonable as of the date thereof, such expectations are based
on certain assumptions regarding the progress of product
development efforts under collaborative agreements, the
execution of new collaborative agreements, and other factors
relating to our growth. Such expectations may not materialize if
product development efforts, including any necessary trials of
our potential drug candidates, are delayed or suspended, if
positive early results are not repeated in later studies or in
humans, if negotiations with potential collaborators are delayed
or unsuccessful, if we are unsuccessful at integrating acquired
assets or technologies, if our planned transition to a drug
discovery and development company takes longer or is more
expensive than we anticipated, or if other assumptions prove
incorrect. As a result, actual results could differ materially
from those currently anticipated. See also the risks and
uncertainties discussed in our Annual Report on Form 10-K
for the year ended December 31, 2003 filed on
March 12, 2004.

Liquidity and Capital Resources

Increase/(Decrease)

September 30,

December 31,

2004

2003

$

%

(In millions)

Cash, cash equivalents and marketable securities

$

77.0

$

76.7

$

0.3



Working capital

56.9

54.7

2.2

4

%

Q3 YTD

Q3 YTD

2004

2003

Cash flow from:

Operating activities

$

6.0

$

0.7

$

5.3

741

%

Investing activities

(0.8

)

(4.4

)

3.6

82

%

Financing activities

(4.3

)

(2.9

)

(1.5

)

(50

)%

Cash flow from operating
activities. The uses of our cash flow
from operating activities have primarily consisted of salaries
and wages for our employees, facility and facility-related costs
for our offices and laboratories, fees paid in connection with
preclinical and clinical studies, laboratory supplies and
materials, and professional fees. The sources of our cash flow
from operating activities have consisted of payments from our
collaborators for services performed or upfront payments for
future services. For the nine months ended September 30,
2004, the net source of funds of $6.0 million was primarily
due to the receipts of upfront research funding from Roche of
$15 million, an operating profit (excluding non-cash
charges) of $1.9 million and $0.8 million related to
reductions in prepaid assets due to the timing of prepayments
for service contracts, offset by $2.2 million related to
payments of severance and facility related restructuring costs,
$2.7 million related to decreases in accounts payable and
other accruals resulting from the payment in 2004 of annual
bonuses and other accruals at December 31, 2003, and
$6.7 million related to recognition of deferred revenues.

Cash flow from investing
activities. For the nine months ended
September 30, 2004, the net use of $0.8 million was
comprised of acquisitions of fixed assets of $1.2 million,
partially offset by proceeds from maturity or sale of marketable
securities, net of investments, of $0.4 million. The
composition and mix of cash, cash equivalents and marketable
securities may change frequently as a result of the
Companys constant evaluation of conditions in financial
markets, the maturity of specific investments, and the
Companys near term need for liquidity.

Cash flow from financing
activities. For the nine months ended
September 30, 2004, the net use of $4.3 million was
comprised of principal repayments on long-term debt of
$4.7 million, partially offset by the cash proceeds from
the issuance of common stock.

We have reported positive cash flow from
operations for five consecutive years. We expect that our
available cash and marketable securities of $77 million at
September 30, 2004, together with operating revenues and
investment income, will be sufficient to finance our working
capital and capital requirements for the next three years. In
April 2004, we entered into a strategic alliance agreement with
Roche, under which we received $15 million in immediate
research funding and could receive up to $276 million in
payments, plus

royalties. In addition, we are currently
considering raising additional capital through a public offering
of our securities. On December 15, 2003 we filed a shelf
registration statement on Form S-3 with the Securities and
Exchange Commission covering securities having an aggregate
maximum value at the time of sale of $50 million.

Our cash requirements may vary materially from
those now planned for development activities and facility
enhancements depending upon the results of our drug discovery
and development strategies, our ability to enter into any
additional corporate collaborations in the future and the terms
of such collaborations, results of research and development, the
need for currently unanticipated capital expenditures,
competitive and technological advances, acquisitions and other
factors. We cannot guarantee that we will be able to obtain
additional customers for our chemistry services, or that such
services will produce revenues adequate to fund our operating
expenses. We cannot guarantee that we will be able to develop
any of our drug candidates into a commercial product. If we
experience increased losses, we may have to seek additional
financing from public and private sale of our securities,
including equity securities. There can be no assurance that
additional funding will be available when needed or on
acceptable terms.

Our principal contractual obligations were
comprised of the following as of September 30, 2004 (in
thousands):

Between

Between

Under

1-4

4-7

After 7

Total

1 year

years

years

years

Long-term debt obligations

$

2,285

$

1,865

$

420

$



$



Capital lease obligations

170

127

43





Operating lease obligations

8,936

2,852

4,407

1,677



Purchase obligations

2,313

1,933

380





Total

$

13,704

$

6,777

$

5,250

$

1,677

$



Included in the total minimum payments for
operating leases is approximately $5.9 million related to
unoccupied real estate in California which was accrued as a
liability, net of contractual sublease income, as a part of the
Companys restructuring actions in 2002, and as
subsequently adjusted (see Restructuring actions below).
Purchase obligations are comprised primarily of outsourced
preclinical and clinical trial expenses and payments to license
certain intellectual property to support the Companys
research efforts.

Critical Accounting Policies and
Estimates

A critical accounting policy is one
which is both important to the portrayal of the Companys
financial condition and results and requires managements
most difficult, subjective or complex judgments, often as a
result of the need to make estimates about the effect of matters
that are inherently uncertain. See the discussion in our
significant accounting policies in Note 2 to the
Consolidated Financial Statements included in our Annual Report
on Form 10-K for the year ended December 31, 2003 filed
with the Security and Exchange Commission on March 12, 2004
for additional information.

Revenue recognition

Historically, ArQule has entered into various
collaborative agreements with pharmaceutical and biotechnology
companies under which ArQule produces and delivers compound
arrays and provides research and development services. In each
instance, the Company analyzes each distinct revenue element of
the contract to determine the basis for revenue recognition.
Revenue for each element is generally recognized over the period
compounds are delivered and/ or services are performed, provided
there is a contractual obligation on behalf of the customer to
pay ArQule and payment is reasonably assured. The nature of each
distinct revenue element, the facts surrounding the services
provided, and ArQules ongoing obligations to provide those
services dictate how revenue is recognized for each revenue
element. This accounting conforms to Generally Accepted
Accounting Principles in the United States, in particular Staff
Accounting Bulletin No. 104,

Revenue Recognition in Financial Statements, and
is disclosed more fully in Note 2 to the Consolidated
Financial Statements included in our latest Annual Report on
Form 10-K.

In May 2003, the Financial Accounting Standards
Board reached a consensus on Emerging Issues Task Force
No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables (EITF 00-21).
EITF 00-21 addresses how to determine whether an
arrangement involving multiple deliverables contains more than
one unit of accounting. In applying the guidance, revenue
arrangements with multiple deliverables can only be considered
as separate units of accounting if: a) the delivered item
has value to the customer on a standalone basis, b) there
is objective and reliable evidence of the fair value of the
undelivered items and c) if the right of return exists,
delivery of the undelivered items is considered probable and
substantially in the control of the vendor. If these criteria
are not met, the revenue elements must be considered a single
unit of accounting for purposes of revenue recognition.
EITF 00-21 became effective for new revenue arrangements
entered into after July 30, 2003.

In February 2004, the Company entered into an
amended contract with Pfizer. The amendment modified the
quantity and composition of compounds to be produced and
delivered by ArQule, with a corresponding adjustment to the
remaining contractual billings for undelivered elements under
the contract. We concluded that the modification was substantial
enough to require evaluation of the contract to determine if
EITF 00-21 applied. We concluded that because the contract
does contain multiple deliverables (license to technology,
research services and compound deliveries) EITF 00-21 did
apply. We determined that there was not sufficient evidence of
fair value of the undelivered elements (compounds), and
therefore the amended contract represented a single unit of
accounting for revenue recognition purposes. As a result, in Q1
2004 ArQule began treating the amended Pfizer agreement as a
single unit of accounting and recognizing revenue based on the
delivery and acceptance of compounds against the contractual
compound delivery schedule.

On April 2, 2004, ArQule announced an
alliance with Hoffmann-La Roche (Roche) to discover
and develop drug candidates targeting the E2F biological
pathway. The alliance includes a compound which is currently in
phase 1 clinical development. Under the terms of the
agreement, Roche obtained an option to license ArQules E2F
program in the field of cancer therapy. Roche provided immediate
research funding of $15 million, and financial support for
ongoing research and development. ArQule is responsible for
advancing drug candidates from early stage development into
phase 2 trials. Roche may opt to license worldwide rights
for the development and commercialization of products resulting
from this collaboration by paying an option fee. Assuming the
successful development and commercialization of a compound under
the program, ArQule could receive up to $276 million in
pre-determined payments, plus royalties based on net sales.
Additionally, ArQule has the option to co-promote products in
the U.S. ArQule considers the development portion of the
arrangement to be a single unit of accounting under
EITF 00-21 for purposes of revenue recognition, and will
recognize the initial and ongoing development payments as
research and development revenue over the maximum estimated
development period. We estimate the maximum development period
could extend until December 2009, although this period may
ultimately be shorter depending upon the outcome of the
development work, which would result in accelerated recognition
of the development revenue. Milestone and royalty payments will
be recognized as revenue when earned. The cost associated with
satisfying the Roche contract is included in research and
development expense in the Consolidated Statement of Operations.

The decrease in total revenue in the third
quarter of 2004 compared to the third quarter of 2003 primarily
reflects (a) no compound development revenue in 2004 from
Bayer under a contract which ended in the third quarter 2003,
compared to $2.2 million in Q3 2003, and (b) no
compound delivery revenue from Sankyo under a contract which
ended June 30, 2004, compared to $0.9 million in Q3
2003. These decreases were partially offset by the Q3 2004
recognition of $1.7 million of research and development
revenue related to the strategic alliance agreement with Roche.
The decrease in revenue for the nine months ended
September 30, 2004 compared to the same period of 2003 is
due to reductions in compound development revenue from Bayer of
$6.8 million, Sankyo of $1.0 million and Pharmacia of
$0.8 million as the result of contracts which ended at
various times in 2003 and 2004, and a reduction of revenue from
Pfizer of $2.6 million resulting from the February 2004
amendment to the collaborative agreement. These decreases were
partially offset by the receipt of a milestone payment from
Wyeth resulting from the filing of an investigative new drug
application with the U.S. Food and Drug Administration for a
compound whose discovery was facilitated by a collaborative
program with ArQule, and the inclusion of $3.3 million of
research and development revenue from Roche. We expect compound
development revenue to decrease in 2004 as a result of the
amended Pfizer agreement and the completion of the Bayer, Sankyo
and Pharmacia contracts, but to be partially offset by the
inclusion of research and development revenue from Roche.

Cost of revenue  compound
development

Increase/(Decrease)

2004

2003

$

%

(In millions)

For the three months ended September 30:

Cost of revenue  compound development

$

7.8

$

8.9

$

(1.1

)

(12

)%

Compound development gross margin %

39.6

%

44.4

%

n/a

(4.8

)% pts

For the nine months ended September 30:

Cost of revenue  compound development

$

23.8

$

27.1

$

(3.2

)

(12

)%

Compound development gross margin %

35.7

%

42.5

%

n/a

(6.8

)% pts

Cost of revenue decreased in the three and nine
months ended September 30, 2004 compared to the same
periods of 2003 due to reduced material and supply costs
necessary to satisfy the Bayer, Sankyo and Pharmacia programs,
which ended at various times in 2003 and 2004, lower
depreciation charges resulting from reduced capital spending in
new equipment and a lower depreciable basis in existing capital
equipment, and a reduction in personnel dedicated to compound
development as a result of the amended Pfizer collaborative
agreement and the corporate restructuring in the first quarter
of 2004 (See Restructuring actions below). Compound development
gross margin percentages were lower in the three and nine months
ending September 30, 2004 compared to the same periods last
year due partially to higher gross margins in the 2003 periods
as a result of the recognition of deferred revenue from Bayer at
the end of that contract for which the associated costs were
incurred in prior years and partially to the lower overall level
of revenue in 2004 available to offset fixed overhead and
facility-related expenses. We anticipate cost of revenue in 2004
will continue to be lower than 2003 based on the lower revenue
levels.

Research and development

Increase/(Decrease)

2004

2003

$

%

(In millions)

For the three months ended September 30:

Research and development

$

5.0

$

4.7

$

0.3

6

%

For the nine months ended September 30:

Research and development

$

14.7

$

12.9

$

1.8

14

%

The increase in research and development expense
in the three and nine months ended September 30, 2004
compared to the comparable periods of 2003 reflects the hiring
of additional scientists, increased laboratory and facility
expenses, and the cost of preclinical and clinical studies to
further develop the

Companys E2F program and other cancer
programs. At September 30, 2004, we had
approximately 66 employees dedicated to our research and
development program, up from 47 at December 31, 2003 and 44
at September 30, 2003. We expect research and development
expenses to continue to increase throughout 2004 as we expand
our oncology discovery pipeline and begin preclinical and
clinical trials as part of the development process.

Marketing, general and
administrative

Increase/(Decrease)

2004

2003

$

%

(In millions)

For the three months ended September 30:

Marketing, general and administrative

$

2.1

$

2.3

(0.2

)

(10

)%

For the six months ended September 30:

Marketing, general and administrative

$

6.9

$

7.2

(0.2

)

(3

)%

Marketing, general and administrative expenses
decreased slightly in the three and nine months ended
September 30, 2004 compared to the comparable periods of
2003. In February 2004, we eliminated 16 administrative
positions as part of our restructuring actions to reallocate
resources to our oncology and drug discovery efforts. The cost
savings associated with these personnel reductions were
partially offset by increased legal expenses related to the
negotiation of the alliance agreement with Roche in the first
quarter of 2004 and increased costs associated with protecting
our intellectual property.

Restructuring actions

In the first quarter of 2004, we implemented a
restructuring to shift resources from our chemical technologies
business to our internal cancer therapy research. The
restructuring included the termination of 53 staff and
managerial employees, or approximately 18% of the workforce, in
the following areas: 30 in chemistry production positions, 7 in
chemistry-based research and development positions and 16 in
administrative positions. The Company anticipates annualized
saving of approximately $4.4 million associated with the
terminations. In connection with these actions we recorded a
restructuring charge of $1.1 million in the first quarter
of 2004 for termination benefits.

In connection with a restructuring in December
2002, we recorded a restructuring charge related to the closure
of our facility in Redwood City, California. As of
December 31, 2003 we had a remaining accrual of
$6.2 million that primarily represented the remaining lease
payments on our primary lease obligation less an estimate of
sublease income. In the third quarter of 2004, we entered into a
sublease for the California facility with Threshold
Pharmaceuticals, Inc. The term of the sublease extends through
2010, the remaining term of the Companys primary lease
obligation. As a result of signing the sublease, we reassessed
the remaining restructuring accrual and, since the sublease was
on terms more favorable than previously estimated, we recorded a
$1.5 million restructuring credit in the third quarter of
2004.

Year-to-date activity against the restructuring
accrual (which is included in accrued liabilities in the
Consolidated Balance Sheet) was as follows (in thousands):

2004

Balance as of

Provisions/

2004

Balance as of

December 31, 2003

(Credits)

Payments

September 30, 2004

Termination benefits

$

10

$

1,072

$

(1,082

)

$



Facility-related

6,160

(1,496

)

(1,024

)

3,640

Other charges

69



(69

)



Total restructuring accrual

$

6,239

$

(424

)

$

(2,175

)

$

3,640

As of September 30, 2004, all employee
termination benefits have been paid. The facility-related
accrual, which is primarily comprised of the difference between
the Companys lease obligation for its California

facility and the amount of sublease payments it
will receive under its sublease agreement with Threshold
Pharmaceuticals, Inc., will be paid out through 2010.

Net investment income

Increase/(Decrease)

2004

2003

$

%

(In millions)

For the three months ended September 30:

Net investment income

$

0.3

$

0.2

$

0.2

111

%

For the nine months ended September 30:

Net investment income

$

0.7

$

0.4

$

0.3

65

%

The increase in net investment income reflects
reduced interest expense due to lower outstanding debt principal
and higher investment yields on marketable securities.

Net income (loss)

Increase/(Decrease)

2004

2003

$

%

(In millions)

For the three months ended September 30:

Net income (loss)

$

1.5

$

(29.9

)

$

31.4

na

For the nine months ended September 30:

Net income (loss)

(3.9

)

$

(29.6

)

$

25.7

87

%

The improvements in net income (loss) in the
three and nine months ended September 30, 2004 compared to
the same periods of 2003 are due to the $30.4 million
write-off of in-process research and development in Q3 2003
associated with the Companys acquisition of Cyclis, and
the $1.5 million restructuring credit in Q3 2004 associated
with subleasing the Companys California facility on more
favorable terms than previously estimated. Excluding these
factors, results in the 2004 periods were less profitable than
the comparable 2003 periods due to the lower compound
development revenue in 2004, increased research and development
spending and the restructuring charge in the first quarter of
2004, partially offset by 2004 research and development revenue.

Item 3.

Quantitative and Qualitative Disclosures
About Market Risk

As part of our investment portfolio we own
financial instruments that are sensitive to market risk Our
investment portfolio is used to preserve our capital until it is
used to fund operations including our research and development
activities. None of these market-risk sensitive instruments is
held for trading purposes. We invest our cash primarily in money
market mutual funds and U.S. Government and other
investment-grade debt securities. These investments are
evaluated quarterly to determine the fair value of the
portfolio. Our investment portfolio includes only marketable
securities with active secondary or resale markets to help
ensure liquidity. We have implemented policies regarding the
amount and creditworthiness of investments. Due to the
conservative nature of these policies, we do not believe we have
material exposure from market risk.

Our use of derivative financial instruments is
limited to the utilization of interest rate swap agreements. Any
differences paid or received on interest rate swap agreements
are recognized as adjustments to interest expense over the life
of each swap, thereby adjusting the effective interest rate of
the underlying obligations. There were no such agreements
outstanding on September 30, 2004.

See Notes 2 and 12 to the consolidated financial
statements in ArQules 2003 Annual Report on Form 10-K
filed March 12, 2004 for a description of our use of
derivatives and other financial instruments. The carrying
amounts reflected in the consolidated balance sheet of cash and
cash equivalents, trade receivables, and trade payables
approximate fair value at September 30, 2004 due to the
short-term maturities of these instruments.

Under the supervision and with the participation
of the Companys President and Chief Executive Officer and
Chief Financial Officer (its principal executive officer and
principal accounting and financial officer), the Company has
evaluated the effectiveness of the design and operation of its
disclosure controls and procedures. Based on that evaluation,
the President and Chief Executive Officer and Chief Financial
Officer have concluded that these disclosure controls and
procedures are effective as of September 30, 2004. There
were no changes in the Companys internal controls and
procedures over financial reporting during the quarter ended
September 30, 2004 that have materially affected, or are
reasonably likely to materially affect, the internal control
over financial reporting.

PART II  OTHER
INFORMATION

Item 1.

Legal Proceeding.

This information as set forth in Note 6 of
Notes to Consolidated Financial Statements,
appearing in Item 1 of Part 1 of this report is
incorporated herein by reference.

Through its website at www.arqule.com, the
Company makes available, free of charge, its annual reports on
Form 10-K, quarterly reports on Form 10-Q and current
reports on Form 8-K, and all amendments thereto, as soon as
reasonably practicable after such reports are filed with or
furnished to the Securities and Exchange Commission.